Why the ETF Market Needs More Players

by Will Ashworth | August 20, 2012 6:00 am

Some exchange-traded fund companies are struggling these days, especially those relatively new to the game. Just this past week, two companies — FocusShares and Russell Investment — made significant announcements demonstrating how difficult it is to survive in the ETF business. They’re either closing or may close as many as 35 funds — more than all the funds shuttered in 2011.

What does this mean for investors? I’ll examine some of the possibilities.

In many ways, what’s happening today mirrors the development of the mutual fund many years ago. “Big is better” seems to be the motto, and the statistics bear this out. Of the $1.2 trillion in ETF assets in the U.S., $1 trillion is managed by BlackRock (NYSE:BLK[1]), State Street (NYSE:STT[2]) and Vanguard Group. That’s an 83% market share.

The only bigger concentration I can think of is the wireless business in Canada, where BCE (NYSE:BCE[3]), Rogers Communications (NYSE:RCI[4]) and Telus (NYSE:TU[5]) control 90% of the market. From my experience with wireless in Canada, it’s a bad deal for consumers. Big doesn’t equal better. Never has, never will.

Unfortunately, that’s what makes the ETF a flawed product. We all can understand the concept of owning a basket of stocks based on an index. However, only firms that can bring in the lion’s share of assets stand a chance with consumers focused on liquidity and assets.

Morningstar suggests that Black Rock, State Street and Vanguard bring in $3 out of every $4 in new ETF money. Like the wireless business in Canada, it doesn’t matter how many companies you let compete for mobile customers, it’s still a monopoly, even if not by definition.

In a world where I can stream video from my Mac desktop to my TV, it makes absolutely no sense that the financial services industry can’t create ETFs that can operate from a small asset base. Warren Buffett ran his early partnerships from a bedroom in his house. Today, if the Oracle wanted to set up an ETF, he’d be out of luck.

I write a weekly article for InvestorPlace readers providing ETF alternatives[6] to stock recommendations made by our writers. On several occasions, I’ve suggested FocusShares’ funds[7], including the Focus Morningstar Consumer Cyclical Index ETF (NYSE:FCL[8]) because they’re cheap and use some great sector indexes from Morningstar. Unfortunately, because the fund only had $2.9 million in assets, investors shied away from it, despite an expense ratio of 0.19%. Only the Consumer Discretionary Select Sector SPDR (NYSE:XLY[9]) charges less.

With Scottrade (owner of FocusShares) announcing that it’s closing its ETF business, it leaves investors with one less independent voice in a very big old boy’s club. ETF experts suggest this type of monopolistic competition creates lower prices because it’s the only way to gain market share when wooing consumers faced with choosing from three large competitors with no discernible differences.

From my experience, when the consolidation train gets rolling, choices diminish and prices flatline or gradually rise as consumers become apathetic. Asset management is one of the few industries that doesn’t have economies of scale. The SPDR S&P 500 (NYSE:SPY[10]) had net assets of $58 billion as of September 30, 2006, and an expense ratio of 0.08%. Today, it has almost $104 billion in assets and charges 0.09%. State Street can argue all it wants that 0.09% is still a great deal, and it is, but the fee should be half that given the size of assets.

More troubling than FocusShares closing its doors is the news Russell Investments is reviewing its ETF business and reducing its staff by up to 30 people. Russell is one of the leading index designers anywhere, and yet it’s also having trouble making ends meet. Carolyn Hill of Index Universe[11] believes that Russell will shutter all but six of its 26 funds, choosing to keep open the Russell 1000 Low Volatility ETF (NYSE:LVOL[12]) and its other profitable funds.

If that happens, it will only be a matter of time before the six remaining get gobbled up and the ETF division shut completely.

Here’s the major flaw in the whole system — it’s too cumbersome. Why can’t retail investors simply go to Folio Investing or Scottrade for that matter and ask for a portfolio based the Russell-Axioma U.S. Large Cap Low Volatility index, pay a small fee to Russell for use of the index and another fee to Folio Investing to reconstitute the fund monthly?

The creation of indexes, while complicated, don’t require the overhead ETF companies do. The power would then lie with the index companies that are essentially creating music to sell over iTunes, etc. By doing this, people with Warren Buffett-like talent but a limited budget, would be able to enter the asset management business.

As it stands now, the gates to the kingdom are closing quickly, and that’s bad news for everyone except the folks at BlackRock, State Street and Vanguard.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.